Julie Jason: When investing long term, handling volatility is a key factor

Julie Jason, Retire Secure

Published 5:27 pm, Saturday, May 24, 2014

A long-term investor who put money to work in the stock market and held on through thick and thin during the financial crisis experienced a rough-and-tumble roller-coaster ride. The question is, was the ride worth it? Let's go back 10 years.

An investor who bought into the stock market, as measured by the S&P 500 Index, 10 years ago and held on through 2013 achieved an annual return of 7.4 percent, according to Morningstar Inc., a provider of market research. You have to reduce that figure somewhat for operating expenses, since an investor would have purchased a mutual fund that replicated the index. The oldest such fund has annual operating expenses of 0.17 percent.

If instead he had put his money in the bank or, better yet, the safest of all investments, 30-day U.S. Treasury bills, he would have been far behind. The annualized return on T-bills was only 1.54 percent for the 10-year period ending Dec. 31, 2013.

For long-term goals such as retirement, it becomes important to recognize that stable investments such as T-bills don't offer real returns after inflation.

In the past 10 years, the inflation-adjusted return on T-bills was a negative 0.81 percent annualized, compared with a positive 4.91 percent annualized for the S&P 500 Index, according to Morningstar.

In the past 20 years, after inflation, T-bills returned 0.47 percent per year, compared with 6.69 percent for the S&P 500 Index.

Are investors benefiting from long-term stock market results?

Studies of investor behavior say no.

It turns out that investors tend to sell at low points and buy at market highs, according to DALBAR Inc., as reported last month in DALBAR's 20th Annual Quantitative Analysis of Investor Behavior for 2014.

According to DALBAR: "Investors continue to react to market movements and the news. One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets. Recommendations by the investment community to remain invested have had little effect on what investors actually do. The result is that the alpha created by the portfolio is lost to the average investor, who generally abandons investments at inopportune times, often in response to bad news."

As C. Thomas Howard says in his book, "Behavioral Portfolio Management," we make investment decisions based on "heuristics": "A heuristic is a shortcut approach to making decisions and, while it often leads to good decisions, in the world of investing such an approach can be highly problematic."

Cognitive errors that interfere with sound investment decisions abound. Not wanting to lose money (who does?) is probably the single biggest reason why people run from volatility.

DALBAR finds that: "Investors tend to sell after experiencing a paper loss and start investing only after the markets have recovered their value. The devastating result of this behavior is participation in the downside while being out of the market during the rise."

Should investors try to beat the market? The answer, of course, is no.

As DALBAR concludes: "The humbling fact has been and always will be that: the average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices, but rather based on their individual path towards a personal goal."

If that goal is your distant retirement, it's important to factor in how volatility affects results over time.